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OpEd: Looming Legal Issues in Cryptocurrency Bankruptcies

By Deal Contributors
Published: July 19th, 2022
Several novel issues are likely to arise, including the treatment of custodial funds, the treatment of collateral held by cryptocurrency lenders that go bankrupt, avoidance actions and plan feasibility.

The following article is the second in a two-part series written by Adam Levitin, a Georgetown University Law Center professor and a member of Gordian Crypto Advisors LLC.

The U.S. bankruptcy system is getting its first experience dealing with cryptocurrency businesses. It’s impossible to identify every possible novel cryptocurrency issue in bankruptcy in advance, but several are likely to arise: the treatment of custodial funds; the treatment of collateral held by cryptocurrency lenders that go bankrupt; avoidance actions; the treatment of collateralized crypto loans made to debtors; plan feasibility; and enforcement of orders against decentralized autonomous organizations.

Treatment of Custodial Funds

Cryptocurrency companies, particularly exchanges, often hold customer funds, both cryptocurrencies and cash. The legal capacity in which these funds are held is a matter of some uncertainty. Possible legal characterizations are a bailment, a trust or as “financial assets” governed by Article 8 of the Uniform Commercial Code — all of which would make the custodial funds customer property — or simply as property of the cryptocurrency exchange itself.[1]

Complicating this issue is that some cryptocurrency businesses rehypothecate customer funds — that is, they use customers’ funds as collateral for their own borrowings. When customer funds are rehypothecated, who has rights to the collateral, the customer or the lender? While there are well-established rules for this regarding securities and commodities, it is unclear if those rules would apply to cryptocurrency.

Resolution of the status of customer funds will be a substantial issue, as it will determine the scope of the debtor’s assets and whether the customers are unsecured creditors or will be able to get back their cryptocurrency (to the extent the debtor still holds it).

Treatment of Collateral Held by Debtor-Lenders

Another likely issue is the treatment of collateral held by cryptocurrency companies that make loans to customers. Customers who do not wish to sell their cryptocurrency but want fiat currency can borrow against their cryptocurrency. In such a situation, the cryptocurrency business is holding the crypto as collateral, raising the question about whether the lending relationship is an “executory contract” that the cryptocurrency company can choose to assume or reject in its business judgment.

If the contract is assumed, it will be performed according to its terms — if the customer repays the loan, the collateral will be returned. But if the contract is rejected, then the customer will keep the loan proceeds, the cryptocurrency firm will keep the collateral, and the customer will have an unsecured claim for the extent of the overcollateralization. What is not clear in this situation, however, is whether the claim will be based on the value of the collateral at the bankruptcy date or at the date on which the customer learns of the rejection.

Avoidance Actions

Bankruptcy law lets creditors avoid — that is unwind — certain prebankruptcy transactions. These include transfers made for less than reasonably equivalent value while the debtor is insolvent or undercapitalized (constructive fraudulent transfers) and transfers made to unsecured creditors in the 90 days before bankruptcy (voidable preferences).[2] There are exceptions to avoidance action liability if the transfer involved a security, commodity or repurchase agreement, but if it did not, there is still a question for voidable preferences about whether the transfer falls into an exception for transfers made in the ordinary course of business. A range of transactions could potentially be subject to avoidance actions, including security interests in crypto, margin liquidations, redemption payments and withdrawals by customers.

Treatment of Collateralized Crypto Loans Made to Debtors

Cryptocurrency money markets exist, generally based around overcollateralized lending structured as repo transactions with smart contracts. It is unclear if the security interests in these transactions have been properly perfected, meaning that the necessary actions have been taken to give the security interest priority over competing interests in the collateral. An unperfected security interest can be avoided in bankruptcy.[3]

If these security interests are unperfected, they will likely be avoided, leaving the lenders unsecured and opening the possibility of the debtor clawing back any transfers made to the lenders in the 90 days before bankruptcy, including redemption payments and liquidations of the debtor’s collateral due to a margin trigger.

Plan Feasibility

Confirmation of a Chapter 11 plan requires the bankruptcy court to find that the plan is feasible, meaning that it is likely that the plan can be successfully implemented. For many cryptocurrency businesses, the feasibility of any restructuring is dependent upon unpredictable cryptocurrency prices, which might preclude any feasibility finding.

Enforcement of Orders Against DAOs

Some entities in the crypto world are structured as DAOs — decentralized autonomous organizations. While some DAOs do have a formal legal entity, others are looser, unincorporated collectives. This situation presents a potential complication to enforcement of court orders: Who is liable when no single party has control? Courts have already proved creative in dealing with issues such as service of process to unknown persons at blockchain addresses by allowing service via NFTs; further creativity may be required for courts to enforce orders against nontraditional organizational structures.

[1]Adam J. Levitin, “Not Your Keys, Not Your Coins: Unpriced Credit Risk in Cryptocurrency,” 101 TEX. L. REV. (forthcoming 2022).

[2]11 U.S.C. § 547.

[3]11 U.S.C. § 544(a).

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